What’s the difference between a good and great Manhattan condo deal? Replacement costs

Manhattan condo sales are in a deep slump with sales volumes down to recession-era levels, which means good deals on Manhattan condos can be found in today’s market.  But how do we know when we’ve found a GREAT deal on a condominium? Compound takes you on a behind-the-scenes tour of how to calculate replacement costs, a key metric to help answer that question.

Replacement costs, our conservative friend

Unlike rental apartments, condos tend not to trade on the basis of income or cap rates.  Instead, investors usually look at comparable sales or replacement cost as a method for determining their value. Of the two, replacement cost is the more conservative of the metrics, and that’s why we at Compound defer to it when assessing transactions for our own funds.

Replacement cost measures the cost of rebuilding the same building in the same location. It is calculated by adding the market land value to an estimate of hard and soft construction costs, but that’s not as straightforward as it sounds.

Component #1 - Land cost

Obviously, Manhattan land values prices vary pretty dramatically, with land near Central Park generally commanding the highest prices.

Since 1977, Manhattan has seen the fastest and most prolonged period of land-price growth ever (a few cyclical dips aside). Between 1977 and 1988 and again between 1993 and 2007, annual growth averaged 24% percent. During the dark days between 2009 and 2011, land prices dropped 15%, to $322 per buildable square foot, but today, just 7 years later, they are back above $550.

Once again, land prices are in a bit of a correction. In 2017, the average price per buildable square foot was $558 in Manhattan, down 18% from 2016.

Source: https://commercialobserver.com/2017/01/the-performance-of-the-manhattan-land-market-in-2016/ and Cushman & Wakefield

Figuring out the true value of land can be the hardest part of accurately calculating replacement cost. Land parcels in comparable locations may not have traded recently, so benchmarking the land value is difficult. Other factors such as zoning, tax credits and historic districts further complicate the calculations, as do “ground leases,” which are locations where the developer does not own the parcel outright.

To simplify our “back of the envelope” replacement cost calculation, we use the average price per buildable square foot for Manhattan land south of 96th Street, and we will set aside ground leases from the conversation entirely.  This means that we can estimate land costs at approximately $600 per buildable square foot for an average location in Manhattan [for what time period, 2018?].

Component #2 - Construction and Soft Costs

In Manhattan, construction hard and soft costs average approximately $900 to $1000 per square foot.  (Hard costs include building materials and the labor cost for trades such as plumbing, electrical and HVAC. Soft costs includes things like architect’s fees, advertising campaigns and project management fees.)

When estimating hard and soft costs, we also account for the quality of design and finishes, ceiling heights, and building systems (elevators and windows) in order to accurately estimate what it would cost to replace the building.

It is worth noting that in the past 12 months, new tariffs have dramatically increased the cost of some imported metals (like aluminum and steel), and so construction costs have increased as a result. For example, steel comprises roughly 16% of the total building cost for a typical commercial project, so an increase in steel prices has a big ripple effect on total project costs.

Today, New York City has the highest hard construction costs in the world.  These prices are higher than San Francisco (#2), Zurich (#3), Hong Kong (#4) and London (#5).

What does all of this mean when it comes to evaluating condo prices?

Replacement cost averages about $1600 per square foot in the borough of Manhattan, excluding the incremental cost of a prime location, luxury finishes or increased steel prices. In addition, a developer will have carrying costs related to financing the project which further inflate the replacement cost, which our $1600 estimate does not include.

At Compound, we’re building a portfolio of properties for each of our real estate thematic funds, and replacement cost is a critical metric to evaluate acquisition opportunities for these properties. Keep it in mind for yourself, too.